2023-04-14 13:03:30 ET
Summary
- In our view, investors are significantly undervaluing Alibaba and in fact giving away Alibaba's Cloud Segment "for free."
- We consider that Alibaba is trading significantly below its intrinsic value, which we believe is $496BN, with mean-reversion offering the opportunity to generate significant Alpha.
- Our calculations show that Alibaba could achieve a return of more than 19.72% CAGR over the next ten years, crossing the $1T mark.
- With our analysis, we see BABA stock as a highly asymmetric risk-return prospect, with downside risk protected by its FCF and great upside potential from unit divestitures.
Investment Thesis
Alibaba (BABA) recently announced that it is splitting its business into 6 units . We think Alibaba is significantly undervalued, as we believe investors are essentially getting Alibaba's cloud segment "for free," despite the fact that it could be worth more than Alibaba's Core Business today.
This article discusses why we think Alibaba is trading significantly below its intrinsic value, and why mean-reversion could be a huge profit opportunity, with the possibility of a CAGR of 19.72% over the next decade.
Bird's-Eye View Alibaba's Business Split
The 6 units into which Alibaba is split consist of smaller businesses. The main segment, Taobao & Tmall, generally brings in the most revenue, and is currently pretty much the driving force behind Alibaba in terms of net income.
As for Alibaba's core business, we include all 5 segments except Cloud Intelligence. If we aggregate the operating profit of all operations, it is easy to see that Alibaba's main business, Taobao & Tmall, is currently driving profits, while all the other 5 segments are taxing the company in their current form. But we believe they are on their way to profitability as Alibaba plans to spin off each division.
Taobao & Tmall
- Segment Enterprise Value: $471.70BN
- Price Target: $178.17
First, the most important part of Alibaba is the absolute core, which will consist of Taobao & Tmall , which are pretty much the only parts that have been profitable. Taobao is a consumer-to-consumer platform, while Tmall is B2C. Both companies target Chinese consumers.
Revenue growth in this segment has also been stunning, with a CAGR of 32.78% between 2014 and 2022, although growth has remained subdued over the last few quarters. On the other hand, operating margins have improved recently.
Especially for an online retailer, Alibaba's core Chinese retail business has impeccable margins, currently around 26.74%. In calculating margins for this segment, we included both revenues and losses from categories outside the 6 newly created segments to reflect Alibaba's true profitability going forward.
This means that we have included both their "innovation initiatives" and their "unallocated" segments in the Taobao & Tmall Business Group. However, we believe that these margins, while remaining well above industry standards, are likely to decline over time as competition increases. Still, we think they will remain high relative to U.S. industry peers, given the nature of the Internet in China and Alibaba's core position in the Chinese Internet. We pretty much agree with Charlie Munger , who still has a stake in the Chinese giant:
In thinking about Alibaba, I got charmed with the idea of their position in the Chinese internet. And I didn't stop to realize they're still a retailer. It's going to be a competitive business the internet, it's not going to be a cakewalk for everybody. (-Charlie Munger)
Market research indicates a 12.4% growth rate in the near future for China's e-commerce industry , which we will use in our forecast. At a CAGR of 12.4%, Alibaba should reach total revenue of US$302.37 billion by 2032, even though we think Alibaba could surpass this growth given its past growth rate, which has been above the industry average, reaching 22% between 2014 and 2021. To put this projected revenue growth in context: As of now, Amazon (AMZN) is already doing $514BN in annual revenue.
As for operating margins, as mentioned above, we believe they are likely to decline over the next decade given the competitive nature of the Internet. Retailers such as Walmart (WMT), Target (TGT) and Amazon tend to have notoriously low margins, typically between 4% and 8%, while other platforms such as eBay (EBAY) and Etsy (ETSY), which are C2C, have relatively high margins.
Since Tmall and Taobao are both, we take a blended average, with Alibaba's margins, currently around 27%, likely to settle at 12%, still above US retail, but with margins halved. This would bring operating income to a total of $36.28 billion.
In terms of valuation, we assume an Operating Income multiple of 13x, which is lower than the industry's multiple , which is around 19.73 in the United States. At that multiple, this segment alone is expected to be worth about $471.70 billion by 2032, or $178.17 in today's share price.
Global Digital Business
- Segment Enterprise Value: $40.78BN
- Price Target: $15.40
Alibaba's second business, their Global Digital Business includes Alibaba.com, AliExpress, Lazada and others and is mainly focused on international markets, as most people in the US/EU learn about Alibaba. Yet, it only accounts for about 8% of revenue and is still a money-losing activity.
Given the improvement in operating margins in recent quarters, we assume that this unit will be profitable by 2032, reaching the average operating margin of 2.3% in online retail. Margins have improved from over -20% to around -8.53% according to our measurements, with a margin of 2.3% considered achievable.
Based on average growth projections for global e-commerce, we believe this segment can generate $21.81BN by 2032. At the industry average EV/Sales ratio of 1.87x, we think this unit can reach an expected EV of $40.78BN by 2032, or $15.40 at the current share price.
Cainiao
- Segment Enterprise Value: $49.97BN
- Price Target: $18.87
The third unit of Alibaba's core business, Cainiao, is essential to Alibaba's operations as it ensures smooth 24-hour delivery across China. The revenue growth of this unit has been quite amazing, with a CAGR of 46.49% since 2018. Widely regarded as one of the largest Unicorns in China, this unit was already valued in 2018 at $100BN Yuan, or $14.56BN, despite doing only $1.08BN at the time.
This unit, like others, is not yet profitable, but margins are improving and moving toward profitability. Operating margins are currently around -6.59% for the last 12 months, but are improving. Similar to the 46.49% CAGR in revenue achieved by Cainiao, e-commerce logistics is a booming industry, expected to grow at a CAGR of 19.5% between now and 2030.
Therefore, we believe Cainiao can generate approximately $46.27BN in revenue by 2032. At a 1.08x market multiple for logistics, that would put Cainiao at an EV of $49.97BN by 2032. We think this is a reasonable valuation, given the previous valuation of $14.56BN in 2018 against $1.08BN in revenue. An EV of $49.97BN would equal about $18.87 in today's share price.
Local Consumer Services
- Segment Enterprise Value: $26.65BN
- Price Target: $10.07
Another of the 5 segments, which we include in the core of Alibaba, is a mix of different companies considered "Local Consumer Services." These are mainly the DoorDash (DASH), Takeaway.com, Uber Eats, Yelp, Booking.com etc. in the Chinese economy. We will use an EV/Sales that is the market average of 2.35 for this unit, which also matches U.S. companies such as Uber, Yelp, etc.
Although this market is expected to grow at a CAGR of 10.3% between now and 2030, and the segment has grown by 26.36% over the past 4 years, we will still assign it a low growth rate as it is currently bleeding a lot of cash. Operating margins are currently around -41.58% as of Q4 2022, like many other Unicorn companies currently operating in this space.
We assign this unit a growth rate of 5.15%, or half of what the market forecasts for a total of $11.34BN by 2032. At an EV/Sales multiple of 2.35x, this unit should be worth about $26.65BN in EV by 2032, similar to DoorDash's current valuation at $24.09BN. A valuation of $26.65BN would translate into $10.07 off the current share price.
Digital Media and Entertainment Group
- Segment Enterprise Value: $26.34BN
- Price Target: $9.95
The last segment, Digital Media & Entertainment, also consists of a whole range of different companies. One of them is Youku, one of the largest video hosting and streaming companies in China. 13 years ago, in 2010, the company was already valued at $3.3BN when it was listed on the NYSE, and bought out a few years later for $5.40BN .
Yet Youku is just one of the group's segments, with all the companies together accounting for about $4.53BN in the past 12 months. The segment is also not profitable, even if it is heading toward profitability.
Despite the huge growth between 2016 and 2022, we assume a growth rate of 5.6%, the projected growth rate of China's entertainment industry . We believe this segment can generate $8.78 billion in revenue by 2032 as it moves toward profitability.
The average EV/Sales ratio for the entertainment industry is 3.06x, meaning that, according to our estimates, this segment will generate $26.34BN in enterprise value or $9.95 in value per share by 2032.
Core Business: Total
Adding all these segments together, we think Alibaba's Core Business could reach $683.46BN in market capital, or $258.15 per share. We also added Alibaba's excess cash and the valuation of Ant Group, of which they own 33% at the last valuation. Based on the current share price, which is $96.17, we expect these units alone to yield a CAGR of 10.38% over the next 10 years.
In other words, we believe these core segments already have the potential to outperform the S&P 500, and generate alpha above most benchmarks. In our view, Alibaba is already worth a buy even if we exclude one of its key segments, Cloud.
Alibaba Cloud
- Segment Enterprise Value: $603.18BN
- Price Target: $227.83
And so, for our bonus segment: Alibaba Cloud. When looking at this business, we think it is important to take into account the macroeconomic conditions this segment is currently in, as cloud computing is usually considered inherently slowing down in times of macroeconomic stress.
All other competitors such as Google ( GOOG ) (GOOGL), Microsoft (MSFT) and Amazon have experienced significantly slower growth in these segments, as well as pressure on their margins due to a macroeconomic slowdown. China is not immune to this either, as the Chinese economy has remained locked down relative to the United States for the past 2 years.
Nevertheless, cloud computing still saw tremendous growth for Alibaba, from $125 million in 2014 to a stunning $11.76 billion in 2022 for revenue growth at a CAGR of 65.69%. To our knowledge, Alibaba Cloud is the only segment besides the Taobao & Tmall Group that has been profitable in certain quarters in the past.
In our view, margins are still slightly negative, at -7.41% for Q4 2022, even though it looks like the segment can achieve sustainable profitability in the near term. In general, the Chinese cloud computing market is still in its infancy compared to the United States, which gives us investors an opportunity to still catch the early stages of this growth.
Between now and 2030, Cloud Computing in China is estimated to grow at a CAGR of about 20.8% , with Alibaba Cloud potentially reaching revenues of $77.84 billion in the next decade. We believe these are conservative assumptions given the growth of U.S. peers such as Amazon AWS and Microsoft Azure, and the size of China's cloud computing market expected to reach about $794.55 billion by 2032.
This would even leave potential upwards, as Alibaba's dominance in the Chinese market could result in a size of more than 10% of the total market size. According to the most recent figures , Amazon AWS owns 34% of the U.S. market, followed by Azure with 21%. If we look at operating margins , and those of U.S. peers , we see that Cloud Computing margins improve dramatically over time as providers achieve scale, stagnating at around 25% since 2016, looking at AWS.
We think Alibaba as a leading provider can achieve similar margins, with an estimated operating margin of 25% by 2032, generating 18.95 billion in operating revenue.
When valuing the cloud, because it is an inherently growth-oriented business, valuations tend to get out of hand when looking specifically at Amazon. Currently, AWS is arguably driving all the profits at Amazon, as retailers have been suffering from this inflationary macroeconomic environment lately. This is also why Amazon is currently trading at 85x operating income, thanks largely to AWS.
While we believe Cloud can get such high multiples, we still use the average multiple for the software industry, which is 31.83x with operating margins averaging 21.81%. That would put this segment alone at a valuation of $603.18 billion or $227.83 per share, meaning this Cloud segment alone could be worth more than Alibaba is currently valued after the split.
Complete Picture
To put everything in context, we think Alibaba could be worth up to $1.28T in market cap or $485.98 per share by 2032, surpassing the previous all-time highs of $319 in 2020. In other words, we think Alibaba could post an annualized share price gain of 19.72% by 2032.
That would already make it a Strong Buy in our view. We also asked ourselves what Alibaba's intrinsic value might be, i.e., at what price point we would buy the stock to get additional Alpha above broad benchmarks.
According to our calculations, investors could buy the stock up to a market cap of $496.06 billion to get additional Alpha, as that would be the price point at which Alibaba's CAGR would reach 10%, or generally on par with the market. This would also match the average at which Alibaba has traded for the past 5 years, for an average of $458BN.
We believe this is a similar case to Meta ( META ), in which the stock also traded well below intrinsic value, and saw a strong opportunity for a return to the mean after value was about to unlock thanks to efficiency and a more shareholder-focused outlook. Michael Burry and Charlie Munger, well-known value investors, also have positions, indicating that the company is likely trading well below intrinsic value.
As with Meta, investors were apparently too bullish in 2021 and far too bearish in 2022, resulting in huge swings and eventually a return to the mean, which has already resulted in one of our best analyses to date. To give perspective, we gave Meta a Buy rating at $113.02, based on excessive bearish sentiment and near-term headwinds, which we believe also applies to Alibaba.
And finally, as most investors know, rule No. 1 of investing is: don't lose money. Or as we like to put it: look down, not up. So we also see a wide margin of safety and downside protection, as the stock is only trading at about 11.4x free cash flow, and tends to bottom at 10x free cash flow in 2022. Alibaba also uses this cash flow and deploys it well, buying back $9.66BN worth of shares in 2022 alone.
Risks
As with any investment, there are risks involved. These risks for Alibaba can range from currency headwinds to geopolitical risks such as the Chinese government, a regulatory crackdown or a military conflict with Taiwan that could escalate.
On the other hand, we endorse Charlie Munger's view that a conflict in Taiwan is off the table for now, after Russia's hubris on the Eastern European front has shown that an invasion of a foreign country may not work as planned. To mitigate the risks of a delisting , investors could also theoretically buy the underlying variant of the original ADR, which is traded on the Hong Kong Stock Exchange, although in the event of a delisting, we do not think that would do much good for Chinese stocks in general.
We believe that trade between China and the United States is crucial for both sides, and sanctions from either side will do more harm than good for both sides. In addition to the above risks, we also see macroeconomic risks in the form of a lingering economic slowdown, although this is likely to dissipate in the near future as the economy rebounds. Softbank also announced this week that it is largely withdrawing from its position in Alibaba, which could also put pressure on the stock in the near term.
Other macroeconomic shocks, such as the slump in China's real estate market, negative ROE projects, or a population decline could still be headwinds over the next decade, potentially jeopardizing our price target.
The Bottom Line
We raise Alibaba from a "Buy" to a "Strong Buy" based on new value that can be unlocked over the next decade as Alibaba splits into 6 different components. We believe that at the current valuation, investors are getting the cloud segment, which could be worth even more than Alibaba today, for free.
Despite nearly 16x more revenue between 2014 and 2022, and 3.6x more operating income, Alibaba is still trading at the same price range as in 2014 due to current macroeconomic and geopolitical headwinds similar to 2018, which we believe will dissipate in the coming quarters/years. In our opinion, there is a high probability of a return to the mean and the stock is a "Strong Buy."
For further details see:
Buy Alibaba's Core Business, Get Cloud 'For Free'